Written by a seasoned Wall Street veteran (and now newsletter writer) , the below piece does a very nice job of explaining the underlying SVB/Signature bank crisis. I thought I would share it with all of you. Enjoy!
In 2008, seemingly everyone on the 400-person equities trading floor I worked on became overnight experts on the CDS market. |
Before 2008, approximately zero of those people (myself included) could have told you what “CDS” even stood for.
But that’s the nature of these things: The proximate cause of every financial crisis is, by definition, something unexpected.
The good news is that we get to learn a few unexpected things each time.
The bad news is, we quickly forget almost all of it.
It’s a little early for a post-mortem on the great banking crisis of 2023, but I can already tell you what we’ve learned.
And I have a guess as to what we won’t forget.
Lessons from the latest emergency
Let’s start with the acronyms, because, just as 2008 made us experts in CDS, CDOs, and CDO-squared, 2023 is making us experts in financial accounting.
HTM: Held to maturity.
AFS: Available for sale.
HQLA: High-quality liquid assets.
When banks classify an asset as “held to maturity,” accounting rules allow them to disregard any marked-to-market losses if the assets go down.
But if they sell any HTM assets, all of them have to be reclassified as “available for sale.” And marking those assets to market is likely to force a bank to report a huge loss — just the prospect of which can lead to a bank run.
Most bonds held to maturity are likely to be HQLA, because, responding to a nudge from regulators, banks make fewer loans and hold more bonds than they used to.
We expected that would make the banking system safer, but here’s another lesson learned: Capital is not king.
We now know that a bank can fail with 0% loan losses — which is a bit like getting an F on a final exam where you’ve answered all the questions correctly.
By loading up on HQLAs and holding plenty of capital, banks had been studiously preparing for the 2008 exam: They were not going to fail a test of credit risk.
But the exam administered in 2023 was on liquidity risk instead (customers withdrawing deposits), and that was a test banks had not prepared for.
The related lesson here is that duration risk can be worse than credit risk.
In a liquidity crisis, seemingly safe but long-dated assets may be riskier than obviously risky but short-dated assets: If banks had been holding mostly junk bonds instead of government bonds, there’d be no crisis.
(Or, more accurately, there wouldn’t have been this crisis. We’d eventually have had some other crisis instead.)
2023 has produced a new valuation metric, too: Percent of deposits insured.
To the small extent we previously paid any attention to what percentage of a bank’s deposits were insured, we thought lower was better: Insured deposits were sleepy and boring. Uninsured deposits were dynamic and growing.
In 2023, however, we want the opposite: Sleepy deposits are unlikely to go anywhere. Dynamic deposits are flighty.
The related lesson is that, in banking, growth can be too much of a good thing.
Bank deposits are callable leverage: As Silicon Valley Bank invested the flood of deposits it was so successfully attracting, it added leverage (by buying bonds with borrowed money) — and put itself at the mercy of that leverage being called.
Banks operate at the mercy of their depositors and when depositors call that leverage, it quickly becomes apparent that every bank operates at the pleasure of the government.
Signature Bank was closed by regulators because regulators viewed it as a risk — even while the market viewed it as being worth $8 billion.
They can do that because banking regulators have wide leeway in an emergency, and in 2023 "emergency" has been defined down.
In the 2008 emergency, we learned that some banks are too big to fail.
In the much smaller 2023 emergency, we’ve learned that almost no bank is too small to bail (out).
Getting learned
Just as high school kids have to relearn all the math they forget every summer, you're not going to remember much of this — all nuances will be forgotten as soon as the crisis has passed.
The best we can hope for is to recall a half-sentence lesson from each major crisis:
Black Monday: The stock market is unpredictable.
S&L bust: People are crooks.
LTCM: Leverage is dangerous.
Great Financial Crisis: Credit ratings are useless.
Pandemic: Printing money is inflationary.
All these things are obvious, of course.
But it takes a crisis for us to really learn them.
So here’s the one thing we should really learn this time around:
In 2023, Deposits are liabilities.
When you deposit money with a bank, that’s a liability for the bank.
And when you withdraw it, that can be a problem for the bank.
We knew this already…since 1904, at the very least, per Mr. Sykes’ quote at the top.
But finance lessons constantly have to be re-learned, and that’s the one 2023 will be remembered for reminding us.
